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Productivity is the most important determinant of the standard of living of a group of people, a nation or a planet. Productivity in its simplest form is output per hour worked, and its recent slower growth rate is distressing. This article summarizes why productivity is crucial to our standard of living. The next article explains its determinants and forecast.

The great gains in standard of living have come from higher output per hour. That was true of the United States and Europe during the industrial revolution, and it's true of Asia in recent years . Gain could, theoretically, have come from a change in distribution: more income going to workers, and less to owners of capital. Despite recent talk about inequality, changes in income distribution have not driven rising living standards over long periods of time. Rising incomes result from rising productivity.

Note that when “productivity” is used alone, it usually refers to labor productivity, but the concept can be applied to other factors of production. We sometimes refer to energy productivity (output per unit of energy used), and factory managers look at the ratio of output produced to raw materials used. In this article we focus on labor productivity.

Labor productivity is not well measured. In manufacturing, it’s easy to compare the dollar value of goods produced to the person-hours of labor required to produce those goods. It’s much harder in services. Take banking, for example. Your checking account is clear as mud. The bank provides to you the service of processing checks, for which you don’t pay (aside from exorbitant fees for bounced checks and stop-payments). However, the bank does not pay you a market rate of interest on the money you keep in the your checking account. It’s a trade: free services in exchange for free account balances. Government statisticians estimate the dollar value of the trade, so that the productivity of bankers can be assessed, but the figures are not very precise. Health care is another area where data don’t allow very accurate estimates on productivity. So productivity statistics provide a general tone, not high-fidelity notes.

Productivity is also pro-cyclical: it rises in booms and falls in recessions. Companies do not cut back employment in downturns as much as production drops. Businesses probably want to retain their best workers, even if they are not fully utilizing those people’s talents. As a result, looking at quarter to quarter changes in productivity is misleading. Any strong quarter for gross domestic product will have strong labor productivity. The best way to look at productivity is over longer time periods.

The chart shows how volatile the data are. Interpretation is not easy at all.

Determining the standard of living of a society begins with labor productivity, but it also includes how many workers there are relative to the entire population. For the world, about 52 percent of all people are working age (16 through 64). Japan, has only 37 percent of its population of working age, but South Korea has 63 percent. There’s not too much to be done about the age distribution of population aside from encouraging working-age immigrants. However, it takes a lot of immigrants to outweigh a country’s own population trends, and some countries are not interested in integrating immigrants into their society.

When productivity rises, worker compensation tends to rise in pace. This isn’t true of every specific year, but it’s generally true over long time periods. With higher productivity and the same old wage rate, companies try to hire more workers. The increased demand for labor bids up the wage rate, and the gains from higher productivity flow through to the workers. This does not at all depend on the generosity of companies; it’s simply how competitive markets work.